Deconstructing Smart Beta

February 10, 2015

Investment objective and beliefs:
The adoption of alternate beta often reflects the investment philosophy of an organisation, for example the Yale Model versus the Norwegian Model. The Yale Model is an endowment model of investing, particularly well known for its substantial allocations to alternative asset classes like private equity, real estate and hedge funds. It is based on the assumption that active management is effective in generating returns in these less-efficient asset classes. By contrast, the Norwegian Model is premised on the idea that long-term risk premia can be harvested to achieve long-term returns. Investors who subscribe to this model are often fervent adopters of alternate beta strategies.
Other investors may adopt alternate beta strategies because of their investment objectives and constraints; for example, to better utilise their risk budget, achieve risk diversification, or reduce overall portfolio risk. Meanwhile, investors with a greater risk appetite may wish to employ these strategies as a means to generate higher returns.
However, the adoption of alternate beta is often a strategic rather than a tactical decision and, as a result, requires a high level of commitment. Furthermore, since investing in alternate beta strategies involves taking active investment decisions via passive implementation methods, the investment and governance process is different to the traditional management structure common to most institutions. Successful implementation rests on being able to manage the risk of these strategies in-house because investment decisions are effectively being transferred from active managers to the in-house team.
Selection of factors:
Factors should be chosen on the basis of how they can achieve investment objectives within the confines of constraints such as risk appetite, ESG policies, and so on. Investors will benefit from examining the economic and investment rationale underpinning the candidate factor premia to ascertain whether their returns are derived from market inefficiencies, investor behavioral biases or from a rebalancing premium.
As in asset class-based investing, timing is a challenge. Factors can underperform for long periods of time. For example, value and low volatility factors underperformed during the momentum-driven technology bubble of the late 1990s. Blending factor strategies to exploit their low cross-correlations could potentially alleviate timing difficulties.
Selection of strategies and managers:
Once the right blend of factors has been selected, the next stage is implementation, which involves selecting the best strategies and managers. Broadly speaking, investors can opt for passive implementation that makes use of purely rules-based strategies (such as index strategies), or semi-active implementation, which is systematic but still allows portfolio managers to have some discretion in constructing the portfolio.
In view of the diversity of implementation approaches, the due diligence process is often complex and time-consuming. Investors should be cognizant of the implications associated with different portfolio construction methodologies and their exposure to risk factors.
Figure 2
For a larger view, please click on the image above.
Figure 2
For a larger view, please click on the image above.
 

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